Economic Notes

Firms and how they Operate

- What is a Firm?
o Organisation or enterprise formed by entrepreneurs who bring together FOP to
produce goods/services for sale
o Gathered at a plant, for the purpose of producing goods or services
o When a group of firms that produce a single good or service, or a group of related
good/services are called collectively as an industry
- Aims of the Firm
o The traditional aim of the firm is that of profit maximisation
 To make the best possible use of scarce resources while trying to make the
highest possible profit
 Economic profit is given as Revenue−Economic Cost
 Economic Cost is the total value of explicit costs and implicit costs.
 Explicit costs = payments made to supplier of inputs, while implicit
costs = costs which do not involve a direct payment to a third party,
but is still a sacrifice of some alternative (opportunity cost)
 There are different types of profits
o Normal Profit – Zero Economic Profit
o Supernormal Profit – Positive Economic Profit
o Subnormal Profit – Negative Economic Profit
o Non-traditional objectives
 Series of potentially conflicting aims held by different managers In different
departments of the firm
 Owners aim to
o Receive a decent dividend (Short Run)
o Maximise the long-term value of the company which will
give them a return on their share ownership
 Managers aim to
o Maximise their own utility , which may depend upon a
range of factors such as salary, status , job security, power
and professional excellence
o Consolidate their positions in the company by building up
their own division through empire building
o Enjoy a comfortable existence
o Maximise short-run total revenue, to maximise profit over
some longer time period
o Maximise growth in sales volume over time
 Managers will tend to pursue their alternative goals while maintaining the
minimum level of profits to appease shareholders
 If targets conflict, it will be settled by a bargaining process between groups
Law of Diminishing Marginal Returns
- States that as more units of a variable factor are applied to a given quantity of a fixed factor,
there comes a point beyond which the extra output from additional units of the variable
factor will eventually diminish
o During Stage 1, marginal returns increase, due to the advantages of specialisation,
labour can specialise in different tasks. Machinery is used effectively by additional
workers
o Stage 2 will see each additional unit of labour adds less to TP than the previous unit
of labour i.e. marginal unit is falling
o Total product will reach a maximum and additional units of labour will reduce TP,
due to over-crowding i.e. marginal output is negative (Stage 3)
Theory of Costs in the Short Run
- Fixed Costs of Production
o Total Fixed Costs
 Costs that must be borne, does not change as the level of production
changes
 E.G. If the firm cannot add to , or dispose of its existing factory, it must still
pay depreciation and interest cost it originally borrowed
o Average Fixed Costs
 Amount of fixed costs per unit of output, decline as output rises due to
spreading of overhead costs over more units of output
 Cost

- Variable Costs of Production

o Total Variable Cost
 Costs incurred for use of variable factors, i.e. raw materials and labour
 TVC rises at a decreasing rate as output increase due to division and
specialisation of variable FOP – Stage 1
 TVC then rises at an increasing rate as poorer factor combinations set in at
higher output levels, marginal cost is high
o Average Variable Cost
 TVC per unit of output
 Reaches a minimum then rises (LDMR)
 Cost

o Marginal Cost
 Additional cost incurred in producing an extra unit of output in the short run
while some inputs remain fixed
 If extra units of variable factor that is bought at a fixed price per unit result
in increasing quantities of marginal output, cost must be falling. Once LDMR
starts setting, it will take more workers for output to rise, causing MC to rise
 Cost
 - Total Cost of Production
o Total Cost
 Made up of total fixed costs and total variable costs
 Cost

 Starts above origin because fixed costs have to be incurred even if

production is
o Average Total Cost (Short Run Average Cost )
 Total cost of production per unit output (AFC+AVC)
 Cost

 As AVC and AFC both fall first, ATC also falls first
 AVC begins to rise at a greater rate than AFC falls, and thus ATC continues to
rise
Theory of Costs in the Long Run
- Called the planning curve as it represents the various average costs attainable
o Long Run Average Cost Curve
 Cost


As output rises, average costs fall due to economies of scale. Average costs
then rise due to diseconomies of scale (output falls).
 Rise is not as sharp as in short run, because size of firm can be increased to
deal with output increases more satisfactorily in long run.
Economies/Diseconomies of Scale
- Internal Economies of Scale (TMRWFERM)
o Savings in cost that occur due firm’s expansion, and created by firm’s own policies
o Technical Economies of Scale (FELEB)
 Factor Indivisibility Economies
 Some inputs are minimum size and are large and costly, but can
reduce AC, and cannot be used if output is small
 Larger plant size makes it possible to use indivisible factors
 Economies from Increased Dimensions
 Larger machines and equipment are more efficient as a doubling in
volume requires a less than proportionate increase in surface area
 Linked Process Economies
 Saves time/cost in moving semi-finished product between factories
 Economies arising from Specialisation and Division of Labour
 Workers do simpler jobs – less training needed
 Increase in efficiency – increase in output
 By-Product Economies
 More economical use of by-product materials
 o Managerial/Administrative Economies of Scale
 Functional specialisation by employing specialists (e.g. financial experts)
 Decentralisation of decision-making increases efficiency as flow of
information is reduced to prevent delays
o Marketing Economies
 Bargaining advantages as they buy materials in bulk, and can dictate
requirements in price
 Unit cost of transport is lower as cost of transport doesn’t increase
proportionately
o Financing Economies
 Cheaper and easier to raise funds as banks charge lower interest rates due
to better credit ratings and more collateral
 Public Limited - can raise money through issue of shares and debentures
(public faith)
o Risk-Bearing Economies
 Large firms can diversify output or develop new export markets to address
non-insurable risks
 Materials can be obtained from different sources to guard against events
 Better position to compensate an area of loss with other areas of gain
o Research and Development Economies
 Can obtain laboratories/researchers , as high cost is divided over large
output of firm
o Welfare Economies
 Increase efficiency by provision of welfare services 9e.g. canteen), and can
encourage higher productivity
o Economies of Scope
 Range of products reduces cost of producing each one
 Various overhead costs can be shared among products , such as marketing
and distribution costs
- Internal Diseconomies of Scale
o Complexity of Management
 Requires more skilful and managers who are capable of coordinating and
controlling large enterprises - hard to find
 Ownership and management divorced – principal-agent problem
 Long chain of authority leads to a rigid organisational system, leading to
time lags in decision making (loss of efficiency and higher costs)
o Strained Relationships
 Relationships become impersonal – reducing productivity and efficiency
 Workers may feel that they have a very small part to play in a firm leading to
slacking and apathy
 - External Economies of Scale (CID)
o Savings in cost as a result of expansion of an industry
o Economies of Concentration
 Availability of skilled labour
 Special education institutions can be built to train people in a
particular type of skill
 Firms can join together to develop training facilities
 Lowers cost of training workers
 Well-developed infrastructure
 When firms are concentrated in one area, transport and public
utilities are set up to reduce average costs for individual firms
 Reputation
 When large and well-established, industries build a name,
consumers associate with quality – increasing output
o Economies of Disintegration
 Subsidiary industries will be developed to cater to needs of major industry
and lower average costs of production
 Allows subsidiary firms to produce specialised goods at large scale and enjoy
IEOS
 Process waste products of industry into useful products
o Economies of Information
 Publication of trade journals/ central research institutes to increase
productivity, reducing costs as research costs are shared
- External Diseconomies of Scale
o Increased strain on Infrastructure
 Infrastructure will be taxed to limits as traffic congestion and other
problems can occur – causing loss of time and increased costs
o Rising Costs of FOP
 May create a shortage of FOP, pushing up prices and increasing costs
- Minimum Efficient Scale
o Measures extent of IEOS
o Smallest plant size beyond which no significant IEOS can be achieved (point where
LRAC stops falling)
o Optimum size of firm
The Growth of Firms
- Size of Firm
o Can be compared using quantity of output, sales turnover, market share, no. of
employees and capital stock
- Motives for Growth
o Exploit EOS
o Gain more market power and achieve greater security
o Reduce take-over by other firms
 - Methods of Growth
o Internal Expansion
o Merger
 Vertical integration
 Merger between firms in different stages of a productive process
 Can be backward / forward
o Backward integration is to have greater control over quantity and
quality of raw materials and to have greater security with regards
to delivery
 Can also be used to restrict supplies to competitor
o Forward integration is to secure an adequate number of market
outlets and raise standards of outlets to live up to image of
advertisement
 Horizontal Integration
 Merger between firms at same stage of production in same industry
o Market domination
 Conglomeration
 Neither vertical/horizontal, and are combination of firms not directly
related to each other
 Diversify output and reduce risks of trading
 Ensure long term growth
Existence of Small Firms
- Demand
o Nature of Product
 Bulky and perishable goods are localised
 Specialised Products , religious products have limited markets
o Prestige Markets
 Limited by Price / Cost
o Direct and Personalised Services
 Impossible to have mass production if individual attention is needed
o Geographical Limitations
 Transport costs for large products will be high, and will be local
- Supply
o Diseconomies of Scale setting in early
 IDOS is more than IEOS at an early stage, optimum size is small
o Vertical Disintegration
 When entire production process is broken into series of spate processes
o Low entry barriers
 Easy to set up a small firm when cost is low
o Lack of Capital
o Unwillingness to take greater risks
o Banding
 Independent firms - gain advantages of bulk buying while retaining independence
o Profit-Cycles
 Takes time to grow, outpace rival firms, merge or force them out of business as new
products continually arrive while others disappear
o Non-profit maximisation
 More concerned with prestige/self-employment rather than profit motive
 Family businesses